A February 2007 study by three professors looks at 230 of the U.S.’s largest public company frauds disclosed between 1996 and 2004. The study, entitled “Who Blows the Whistle on Corporate Fraud?” addresses how each fraud was discovered. Consistent with every other study on the subject, employee whistleblowers are the largest discovery mechanism.
Because these were the largest frauds during this period, multiple employees at each company knew at least a portion of what was happening. Consequently, employee whistle blowing could have been an even more important means of discovery. The study notes that employee reporting was not more widespread because employees have considerable disincentives personally. In 82 percent of the cases with employee whistleblowers identified, the whistleblower “alleged they were fired, quit under duress, or had significantly altered responsibilities as a result of bringing the fraud to light.”
The report later notes:
“In no case is the tension between access to information and the lack of incentives to reveal fraud more intense than for employees. Employees clearly have access to information; few, if any, frauds can be committed without involving some interaction among the people within a firm. However, the career incentives against revealing the fraud are stricter for employees than for any other group. … Consequences to being a whistleblower include distancing and retaliation from fellow workers and friends, personal attacks on one’s character during the course of the protracted dispute, and the need to change one’s career.
… The surprising part, thus, is not that most employees do not talk; it is that some talk at all…. The costs of blowing the whistle are eliminated by keeping the identity of the whistleblower concealed.”
In 45 percent of the cases in which employees blew the whistle, the employee remained anonymous. Under Sarbanes-Oxley (which was not in effect for most of the period covered by the study), each whistleblower could have remained anonymous (see Sarbanes-Oxley Section 301(4). Even without such protections that Sarbanes-Oxley provided, the report notes the:
“…paradox of whistle blowing: those with the weakest incentives to blow the whistle (e.g., employees) are the most active, while those with the strongest incentives are surprisingly less frequent actors. …[This occurs because] information is diffuse. Actors with weak incentives have an advantage in whistle blowing because they have superior access to information about the fraud. So, despite having weak incentives, actors with access to information eventually bring frauds to light. In contrast, those with incentives apparently have difficulty accessing credible information to act upon.”
The study also notes that whistleblowers sometimes have trouble getting the credibility in having others believe their reports. For example, HealthSouth was a large and notorious accounting fraud involving made-up capitalized costs that created both fake earnings and imaginary assets:
“Illustrating this potential problem is HealthSouth, where the fraud would likely have been detected and stopped earlier if the concerns of former bookkeeper Michael Vines were heeded when he left the company in May 2002. As emerged after the fact in response to Congressional concerns about how this fraud could have gone undetected for so long, Vines reportedly sent his concerns to Ernst & Young, but was ignored, and then in early 2003, posted his concerns on Yahoo’s web site, where he wrote, ‘I know for a fact that HRC has assets on the books that are made up to trick the auditors.’ This information channel lacked credibility, as suggested in the comments of an online naysayer: ‘If you really had information, you would have shorted the stock and given your info to the appropriate people. You wouldn’t be babbling about it here.’”
The authors (Alexander Dyck from Harvard, Adair Morse from the University of Michigan, and Luigi Zingales from the University of Chicago) recommend that corporate fraud be given similar financial treatment to what now occurs for qui tam whistleblowers under the False Claims Act. The authors note a much higher rate of whistleblower reporting in industries that deal with the federal government, and attribute this difference to the possibility of qui tam lawsuits, in which a portion of recoveries go to the whistleblowers who pursue claims.
Interestingly, the authors also address the common complaint against qui tam suits – that they lead to frivolous suits by gold diggers. The authors state,
“There is no evidence that stronger incentives to blow the whistle lead to more frivolous suits. … Employees respond to incentives and a reward to whistle-blowing leads to a higher rate of detection. This higher rate of detection does not appear to come at the cost of more frivolous suits.”
Importantly, the frauds covered by this study do not include those “caught so early that they never enter the public domain.” Our own experience in operating whistleblower systems is that employees more eagerly report lesser frauds, particularly when there is an additional, higher management level who can ensure the wrongful conduct will be appropriately handled. When upper management is involved in the wrongdoing, our experience is that employees become much more interested in keeping their anonymity, and sometimes avoid reporting details that, although helpful, would more easily attribute them as the whistle-blowing source.
In light of these findings, it is somewhat surprising how many companies that otherwise are interested in good corporate governance operate their whistleblower reporting mechanisms internally. This is particularly true because the cost of operating whistleblower systems using an independent firm is insignificant under any measurement. However, when one recognizes the value of whistleblower systems in detecting fraud, combined with the major reason that whistleblowers do not come forward, the decision to keep this function in-house is even more baffling.
For information on what a whistleblower system should contain, see Best Practices in Whistleblower Systems.